Catching Falling Knives

When the stock market hits new highs, the mood tends to be one of celebration. With the Dow Jones Industrial Average hitting new highs, the media are practically breaking out champagne. If and when the S&P 500 follows though to new highs, I almost expect a national day of celebration to be declared. I am a natural contrarian and as the party ramps up, questions pop up in my mind. What should I be selling right now? What has been driven to levels that my long positions are now overvalued? Are any stocks bid up to the point that I may want to establish some chicken shorts?

Call me crazy, but I do not like exciting markets that are hitting new highs as that is an indication that the greed part of the cycle is dominating. I have never seen that end particularly well for investors.

Additional questions I always examine as markets hit new highs include: What is not working as the market surges forward? Where are the fallen angel stocks that have experienced steep declines as the market rallied? Are any of them too cheap not to own at current prices -- regardless of the market's direction? Are there any bargain issues likely to buck the trend if the market does decline? Is there any useful information in the collective fallen angel stocks and sectors?

This morning I screened for stocks that have not participated in the rally and have gone down big over the past year. I set the screen to find those "falling knife" stocks that have gone down at least 50% over the past year. Research has shown that these stocks are often excellent candidates for contrarian investors -- especially if they are cheap on valuation and have a good chance of survival. I haven't had time to run all the necessary credit scoring tests yet, but some things are evident right away.

One of the first findings of note is that all the stuff that comes out of the ground is getting cheap. If you mine it, it has gone down over the last year. Stocks of gold miners, silver miners and rare earth diggers have sold off by huge amounts, even as the market has climbed higher. Coal, oil, and gas companies are also on the list of biggest losers. If you use to make stuff or provide energy, it is being tossed out by investors. So are the companies that ship basics, such as petroleum products, grains and coal.

This raises some interesting questions in my mind. Although I know that the low natural gas prices play a role in this pricing is it really possible to have an economic recovery that eventually justifies higher stock prices without the energy and materials stocks participating? Although the steel and aluminum stocks are not yet in the falling knife category they are also down over the last year and I just wonder what it is they we are making that does require metals and energy?

This curiosity drove me to see what has been working and which stocks have soared in the past year for a clue as to what is actually happening in the world. The list of top-performing stocks is dominated by the financials. This makes sense as they were incredibly cheap and distressed over the past few years but I am not sure we can base our economic future on selling each other pools of distressed mortgages. The real question is this: Will the improving condition of the financial stocks, especially banks, eventually lead to an economic recovery that provides the type of demand that lifts the metals, miners and energy companies?

Although the political situation will provide some interesting twists and turns, I think the financial system will eventually improve, which will lead to real demand and economic recovery. It may take a few years, but keep in mind that I started buying the battered financials that dominate the top performers list today four years ago. Energy and raw materials stocks are now in the sweet spot of my time frame.

I have a list of 360 stocks that have dropped by 50% or more on the past year. Here is the breakdown:

68 are currently profitable,

97 are expected to be profitable next year,

168 trade for less than book value.

33 are from China (and go straight into the garbage can),

123 are seeing some type of positive insider buying activity and

55 are seeing some insider selling, even as their prices plunge, and are best avoided.

I have now begun the process of looking for those stocks on the falling knives list that will be worth buying. They must be safe and cheap and make good additions to long-term portfolios. I will also be keeping an eye out for longshot gems that offer opportunities for huge long-term payoffs. I will start reporting my findings on Thursday.